Vanguard Group is America's new landlord

Vanguard Group is fast becoming a dominant investor in the U.S. real estate industry.

Securities and Exchange Commission reports compiled by Bloomberg show that the company's mutual funds and exchange-traded funds are now the leading owners of real estate investment trusts (REITs), the tax-protected investor funds that own many of the nation's offices, shopping centers, apartments, hotels, warehouses, and data and storage centers.

Including its indexed stock and REIT-focused funds, Malvern-based Vanguard owns 18 percent of Host Hotels & Resorts, whose portfolio includes Ritz-Carlton, Marriott, and Westin hotels; 15 percent of Simon Property Group, the national mall owner that counts King of Prussia Mall among its holdings; and a similar share of Prologis, the warehouse giant.

Locally, Vanguard funds control 16 percent each of Brandywine Realty Trust, which owns a majority of Center City's highest buildings; Liberty Property Trust, which develops offices for Comcast and is a landlord to Vanguard; and the Pennsylvania Real Estate Investment Trust, which owns the Cherry Hill Mall, Willow Grove Park, and other suburban retail centers, as well as the taxpayer-subsidized redevelopment of the Gallery at Market East in Center City, where PREIT and its partners hope to sell high-rise tower rights as they seek new tenants. Vanguard has similar stakes in other publicly held REITs in the United States.

That 16 percent is more than double the nearly 7 percent stake Vanguard holds in most of the Standard & Poor's 500, the biggest publicly traded companies. Together, Vanguard, BlackRock, and other index funds "own about 30 percent of REIT stocks, and Vanguard is by far the largest" owner, said William Crow, real estate stocks analyst at  Raymond James & Associates in Florida.

Index funds have expanded their holdings in REITs since they were first included in broad stock market indexes in the early 2000s — and especially since last year, when the firms that create stock indexes for investors began categorizing REITs as a separate industry suitable for indexed investments, said Robert Stevenson, a stock analyst at Janney Montgomery Scott in Philadelphia who has been following REITs since the 1990s.

Before the index funds took over, Stevenson said, real estate stock investors were led by a "mafia" of specialized investors who tracked the values of individual properties and property categories and pressed REIT managers when returns lagged.

But now, he said, index funds buy (and sometimes sell) the real estate companies like "robots." As long as the stock is listed in an index, "they don't care if you have an oversupply of apartments coming into the market" — the index funds will still buy as investors give them money.

Such shareholder concentration has benefited big REIT bosses by insulating them from the threat of activist investors, as Vanguard and BlackRock seldom challenge corporate managers, Stevenson said. The concentration also is "making it much more difficult for smaller REITs to go public," he said, because they are not large enough to get into the Russell 2000 or the MSCI REIT indexes that guide the big funds.

Meanwhile, said John Guinee, real estate stock analyst at Stifel Nicolaus & Co., specialized real estate investors are pulling back from the sector as commercial property values flatten and interest rates have started to rise.

"Uneducated buyers" of index funds are boosting REIT prices, even as aging properties the REITs own may be losing value, Guinee said. That makes prices "more volatile" and tends to attract investors who hope to bet against the indexes — but he acknowledged it's no guarantee those speculators will do any better than index-fund holders.

Vanguard's dominance in REITs gives it an embarrassment of riches. Federal tax law requires REITs to limit individual owners to less than 10 percent of their stock, though the companies are allowed to waive that restriction for mutual funds with many small owners. In an attempt to avoid subsidizing sweetheart rental deals, the law ends REIT tax protections when the owner of 10 percent of a REIT also owns 10 percent of a REIT tenant.

Such relationships among public companies are easy to track: For example, Vanguard owns more than 10 percent of pesticide maker FMC Corp., whose headquarters is the lead tenant in Brandywine's 49-story tower above the Schuylkill in University City. But Vanguard's ownership is split among its different Vanguard funds, so the tax benefits it enjoys as the dominant REIT owner seem secure for now.

Still, as it looks ahead, Vanguard has taken steps to reorganize its real estate holdings so it is less likely to end up betting against itself or coming up against tax limits. It has asked its Vanguard REIT Index Fund shareholders to let it buy more real estate-related companies that are not REITs and to set up a second REIT fund for "select clients" in a wider range of property assets. (Janney analyst Stevenson estimates that publicly traded real estate service companies are worth about $25 billion, compared with $1 trillion invested in U.S. REITs.)

Vanguard owns so much real estate through its funds that its interests now line up with "what's best for the retail industry as a whole" — lower landlord costs and higher tenant rents. Noted Jeffrey DeMaso, research director at Adviser Investments in New York, which tracks Vanguard and other big fund companies: When you own all the landlords, competition among them — in which REITs might improve properties and cut rents to attract the best tenants — starts to look not like a natural part of the free-market system favoring the best property managers, but like a nuisance that eats into owners' total profits.

Scholars including Jose Azar at the University of Navarre and Jan Fichtner at the University of Amsterdam have suggested that increasingly concentrated ownership of banking and airline companies already has lessened competition and boosted prices in those industries. They ask: Is that happening in real estate, too?

Vanguard officials defend the economic and social impact of their indexed funds, which are competitively priced and much cheaper than the actively managed funds many of its rivals sell.

"We see no relationship between ownership concentration and market valuation, nor does our size impede our ability to execute in our investment strategies," said spokeswoman Arianna Stefanoni Sherlock.

Indexed funds still own less than 20 percent of stocks overall. Said Stefanoni Sherlock: "Indexing is not a monolithic investment strategy, but is spread through many market caps and investment styles."

Stock analysts say they doubt that index-fund managers will challenge entrenched management at lower-performing REITs the way specialized real estate investors used to do.

In reports to clients of Boenning & Scattergood, the West Conshohocken brokerage, New York real estate stock analyst Floris van Dijkum cited PREIT as an example of a company with high debt, disappointing profits, and a board whose members' average age is 69, compared with 55 for its larger rival Simon Property Group.

Investors feel "frustration at the lack of new blood on the [PREIT] board," van Dijkum told clients this year. "New perspectives might help the company."

PREIT spokeswoman Heather Crowell noted that four board members are new in the last five years.

In a follow-up report last week, he noted that PREIT's stock market value has lately dipped to a fraction of the estimated sale price of its individual malls. But given their track record as "passive" managers, Van Dijkum doesn't expect that Vanguard and the other index managers that are now PREIT's largest owners will force change anytime soon.